On September 15, 2009, the Treasury issued new regulations and a Revenue Procedure aimed at making it easier to modify securitized mortgage loans.

The new regulations provide guidance under which a real estate mortgage investment conduit (“REMIC”) may release liens on or otherwise alter the real property used as collateral for a mortgage, without causing the REMIC to lose its favorable tax status. The new Revenue Procedure greatly expands the circumstances in which a REMIC or a non-REMIC grantor trust is able to conclude that a default is reasonably foreseeable with respect to commercial mortgage loans it holds, thus enabling it to modify those loans without triggering adverse tax consequences.

The new regulations specifically relate to the modification of mortgage loans held by REMICs. Although the scope of the new regulations is not strictly limited to commercial loans, the preamble to the regulations indicates that the newly expanded mortgages” and that the changes to the regulations were “necessary to better accommodate evolving practices in the commercial-mortgage industry.” The guidance under the new Revenue Procedure (Revenue Procedure 2009-45), on the other hand, specifically relates to the modification of commercial mortgage loans, but is equally applicable to those loans held by REMICs and loans held by certain investments trusts that are commonly referred to as “grantor trusts.”

The New REMIC Regulations

The new REMIC regulations clarify and expand the circumstances under which a REMIC may release, substitute, add or otherwise alter the collateral for, a guaranty on, or other form of credit enhancement for, a mortgage loan. Prior to the issuance of the new regulations, there was substantial uncertainty in this regard. Although the regulations generally permitted modifications “occasioned by default or a reasonably foreseeable list of permitted loan modifications includes “certain modifications that are often made to commercial default” of a loan, the regulations also had a specific “defeasance” provision under which a loan would cease to be a “qualified mortgage” for a REMIC if the REMIC released its lien on real property securing the loan without, among other things, obtaining a pledge by the mortgagor of substitute collateral in the form of government securities. It has been unclear whether the defeasance provision was the exclusive provision under which a REMIC could effectively release a lien on real property securing a mortgage loan, thereby limiting the scope of permissible modifications in respect of a loan that is in default or for which a default is reasonably foreseeable. Further, there has been some uncertainty as to whether the defeasance provision limits the ability to partially release a lien on real property (in either a default or non-default context) where the loan to value ratio (“LTV”) of the loan was not significantly affected by the release (for example, where the partial lien release was coupled with a corresponding prepayment of the loan) such that the release might not constitute a “significant modification” of the loan, or the LTV nonetheless did not exceed 125% following the release (such 125% threshold being the maximum LTV that generally would have been permitted at loan origination or upon contribution to the REMIC in order for the pre-modification loan to have been a “qualified mortgage” for the REMIC—the initial “principally secured” requirement).

The new regulations specifically provide that a REMIC may release, substitute, add or otherwise alter the collateral for, a guaranty on, or other form of credit enhancement for, a mortgage loan so long as the loan continues to be “principally secured” by an interest in real property following the release, substitution, addition or other alteration. For this purpose, a loan will continue to be principally secured following a modification if:

(i) as of the date of the modification, the servicer “reasonably believes” that the obligation satisfies the general 125% LTV principally-secured test, determined as of the modification date,¹ or

(ii) the fair market value of the real property securing the loan immediately after the modification equals or exceeds the fair market value of the real property securing the loan immediately before the modification.

The standard set forth in clause (ii), above, for satisfying the “principally secured” test in the context of a modification is intended to bring the test in sync with the longstanding general rule that a decline in the value of collateral following the initial determination of a loan’s LTV upon origination or contribution to a REMIC does not cause the loan to cease to be principally secured by real property. It should be noted that the standard set forth in clause (ii) differs from, and is perhaps stricter than, that which has been applied in prior issued private letter rulings. On the facts provided in those rulings, a reduction in the value of the real property securing a loan was allowed in the context of a lien release that was accompanied by a contemporaneous prepayment of the loan, such that the LTV of the loan was not significantly affected despite the lien release.

As described above, the satisfaction of the standard in clause (i), above, depends on whether the servicer “reasonably believes” that the general 125% LTV test is satisfied as of the modification date. Although such reasonable belief may be based on a current appraisal by an independent appraiser (and the regulations in their proposed form would have required a current appraisal), the new regulations provide that such reasonable belief may also be based on (a) an appraisal obtained in connection  with the origination of the loan that “if appropriate” has been updated for the passage of time and any other changes that might affect the value of the property, (b) a buyer’s purchase price for the real property in the case of a contemporaneous sale of the property in which the buyer assumes the seller’s obligations under the loan, or (c) “[s]ome other commercially reasonable valuation method.” Similarly, the satisfaction of the standard in clause (ii), above, must be established by a current appraisal, an original (and updated) appraisal, or some other commercially reasonable valuation method. In all cases, the servicer must not actually know, or have reason to know, that the applicable standard is not satisfied.

In addition to the above described permitted loan modifications in relation to releases and alterations of collateral, guaranties, and credit enhancements, the new REMIC regulations also permit modifications of the recourse or non-recourse nature of a loan, so long as the loan continues to be principally secured by an interest in real property following the modification (as determined under the tests and standards described above).

The new REMIC regulations further clarify that the defeasance rule is not the exclusive rule under which a REMIC may release a lien on real property. A lien release, outside the context of a defeasance, will be permitted under the circumstances described above, as well as in the context of a default or reasonably foreseeable default of a mortgage loan, or in any other circumstance in which the lien is released as part of a loan modification that would not constitute a “significant modification” (as determined under generally applicable regulations relating to deemed exchanges of debt instruments upon their “significant modification”), so long as, in all cases, the obligation continues to be principally secured by an interest in real property (as determined under the tests and standards described above).

It is important to note that the above described modifications in relation to releases and alterations of collateral, guaranties, and credit enhancements, as well as those relating to the recourse or nonrecourse nature of a loan, need not be occasioned by a default or reasonably foreseeable default of the loan.² Accordingly, modifications of this kind, even in a non-default context, will not be treated as altering the asset composition of the REMIC for purposes of the REMIC’s ability to maintain its REMIC status and should not result in a prohibited transactions tax. However, to the extent any of these modifications are “significant modifications” under the general non-REMIC rules, the REMIC still could recognize gain or loss upon such modifications. For example, if a mortgage loan with a face amount of $100,000 was purchased for $80,000, and a lien on real property securing the loan is released in a manner that results in a “significant modification” of the loan, then, generally, $20,000 of taxable gain would be recognized by the REMIC. The gain, however, should not be subject to a 100% prohibited transactions tax and the modification should not result in other adverse tax consequences to the REMIC, so long as the loan continues to be “principally secured” by real property following the modification, determined under the tests and standards discussed above.

The new REMIC regulations are effective as of September 16, 2009.

Although the new REMIC regulations only relate to modifications of loans held by REMICs, the IRS and the Treasury Department, in a Notice that was issued contemporaneously with the new REMIC regulations (Notice 2009-79), are soliciting comments as to whether additional guidance is needed in relation to the modification of commercial mortgage loans held by investment trusts and have indicated that they continue to study commentators’ recommendations to permit investment trusts to modify commercial mortgage loans to the same extent as REMICs are permitted to modify such loans.

Revenue Procedure 2009-45

As discussed above, a REMIC has flexibility in modifying mortgage loans that are in default or for which a default is reasonably foreseeable (subject to the continued satisfaction of the “principally secured” requirement if the modification involves a release of a lien). Similarly, a fixed investment trust (commonly referred to as a “grantor trust”), which is otherwise prohibited from varying the investments of the trust, has some flexibility to modify mortgages that are in default or for which default is probable in the reasonably foreseeable future.

There has been significant uncertainty as to when a commercial mortgage loan held by a REMIC or investment trust may be modified, or when negotiations regarding the modification of such a loan may begin. Servicers have been hesitant to modify loans held in these securitization vehicles if the loans have not already defaulted or if default on the relevant obligation is not imminent. In the context of commercial mortgage loans, this creates a particular conundrum. Under the terms of many commercial mortgage loans, principal payments are not due until maturity of the loan. Even though a borrower and the applicable servicer may have valid concerns about the borrower’s ability to obtain refinancing to satisfy the principal due at maturity, the borrower under the loan may well be current on its obligations under the loan. The concerns of the borrower and the servicer may well arise significantly before the maturity of the loan such that the default may not be viewed as imminent.

Revenue Procedure 2009-45 generally provides that a commercial mortgage loan held by a REMIC or investment trust is ripe for negotiation and modification so long as

(i) the holder “reasonably believes that there is a significant risk of default of the pre-modification loan upon maturity of the loan or at an earlier date”;

(ii) no more than 10% of the stated principal amount of the assets of the relevant securitization vehicle, as of the end of the three-month startup period in the case of a REMIC and as of all dates on which assets were contributed to the relevant investment trust, constituted loans having payment delinquencies of 30 days or more, or for which default was reasonably foreseeable as of such time;³

(iii) the holder or servicer reasonably believes that the modified loan presents a substantially reduced risk of default.

The reasonable belief of the holder or servicer as to the significance of a risk of default must be “based on a diligent contemporaneous determination of that risk, which may take into account credible written factual representations made by the issuer of the loan if the holder or servicer neither knows nor has reason to know that such representations are false.” The Revenue Procedure clearly states that a holder or servicer may reasonably believe that there is a significant risk of default on a loan even if the loan is currently performing, and that while one relevant factor in the determination of the significance of a risk of default is how far in the future the possible default may be, “[t]here is no maximum period, however, after which default is per se not foreseeable.”

Revenue Procedure 2009-45 applies in respect of loan modifications effected on or after January 1, 2008.

Greater Hope for the Future of Commercial Loans and Commercial Mortgage-Backed Securities

Given reports that more than $150 billion of securitized commercial mortgage loans are scheduled to mature between now and 2012 (the so-called “refinancing cliff”), the Treasury’s issuance of the new REMIC regulations and the Revenue Procedure guidance will be most welcome by those in the real estate industry and those involved in the securitization of commercial mortgage loans. The new guidance may help stave off the potential wave of defaults and foreclosures that may occur if the credit markets remain closed to refinancing.

1. Although a conforming amendment was not made to Section 1.860G-2(a)(2) of the REMIC regulations, it seems appropriate that the fair market value of the securing real property should be reduced on account of senior and paripassu liens for purposes of calculating the LTV as of the modification date in the same manner as the fair market value of the securing real property is reduced on account of such liens when the “principally secured” LTV test is initially applied upon a loan’s origination or contribution to a REMIC.
2. Most other modifications (such as changes in maturity date, interest rate, etc., but not including the assumption of an obligation, the waiver of a due-on-sale clause, or an interest rate conversion under the terms of a convertible mortgage) generally would still need to be occasioned by a default or reasonably foreseeable default of the loan or otherwise not constitute a “significant modification” of the loan under generally applicable rules relating to deemed exchanges of debt instruments. However, the presence of a default or reasonably foreseeable default does not obviate the need to continue to satisfy the “principally secured” test described in the accompanying text if the modifications also involve a release of a real property lien or a change in the recourse or non-recourse nature of the loan.
3. To the extent persons have used or consider using REMICs as vehicles for the workout of troubled mortgages, this 10% limit on the inclusion of delinquent or seriously troubled loans could restrict those REMICs from taking advantage of the more liberal standards of default status set forth in the Revenue Procedure, thereby potentially making the concept of a “workout REMIC” less attractive.